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What are derivatives? | |
作者:佚名 文章来源:本站原创 点击数 更新时间:2008-12-11 13:35:27 文章录入:guoxingxing 责任编辑:guoxingxing | |
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● 林扬圣博士 Dr Joseph Lim
A derivative is a financial instrument whose value is derived (hence the name) from an underlying asset. For example, the value of a warrant depends on the value of the underlying share (or "mother share"). Or the value of a gold futures contract is derived from the current price of gold. Derivatives come in two forms: options and futures.
There are two types of options: a call and a put. A call gives the holder a right, but not the obligation, to purchase a share at a fixed price, known as the exercise price (Warrants and TSRs are essentially calls). A put gives the holder the right, but not the obligation, to tender a share and receive, in return, a fixed price.
If you think that the share price of a company is going to rise, one way to profit from this is to buy its shares. However, if you are wrong, and the share price falls instead, you would have suffered a loss. The size of the loss would depend on how much the price falls, something difficult to know ahead of time. Such an uncertainty may prevent you from acting on your hunch.
However, if from the start you know exactly how much you stand to lose if your hunch is wrong, you may be emboldened to act. This is possible if you buy a call with the exercise price equal to the current share price. The maximum amount you can lose is the price of the call.
Why? Remember that a call gives you the right, but not the obligation, to purchase a share. If the share price rises above the exercise price, you would exercise the option. You pay the exercise price and receive a share which is worth more.
However, if the share price falls below the exercise price, you do nothing. The maximum amount you can lose is the call price, regardless of how much the share price has fallen.
What about the situation where you want to profit from a possible fall in the share price of a company? One way is to sell short its shares. The other is to buy a put with an exercise price equal to the current share price. If the price indeed falls, you would buy a share, tender it with the put and receive the exercise price, placing you in a similar situation had you sold short the shares. Should the price rise instead, your loss would be limited to the price of the put. However, someone who sells short the shares may end up with very substantial losses if the price rises by a large amount.
The price of an option depends on five factors: the share price, the exercise price, the time to expiration, the interest rate and the volatility of the underlying share price.
The higher the share price or the lower the exercise price the more valuable a call. This is because the call gives us the right to buy the share at a fixed price.
Options have lives of up to one year (5 years for warrants). The longer the time to expiration, the more valuable the option. The higher the interest rate, the more a call is worth. A rise in the interest rate makes the present value of the price you pay for the share, the exercise price, lower. Finally, the higher the volatility of the share price, the more valuable the option. Another difference between investing in options and the underlying share arises from the limited life of the option. Unlike options, a forward contract makes you obligated you to either buy or sell an asset at a future date, but at a price determined today. For example, you may enter into a gold forward contract to buy for delivery in February 1999, 100 ounces of gold at a price of US$300 an ounce. Futures contracts are like forward contracts except that the terms of the contract, namely the quantity and the delivery date, are standardised. This makes each contract freely interchangeable with another contract. This permits their trading on an exchange thus enhancing liquidity. Suppose you believe the price of gold will rise next year from increased economic uncertainty, you could act on your belief by buying gold bars. However, a more efficient way is to buy a gold futures contract. Next year, if the price of gold has risen, you would make a profit. However, if the gold price falls, instead, you would sustain a loss having to buy gold at a price much higher than the current market price. Unlike options, a futures contract does not offer limited losses. (The writer is Director, MSc in Applied Finance Program at the National University of Singapore) |
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